In Asset Allocation: Cash (Part 1), we saw how your life cycle phase and risk tolerance significantly impact your target asset allocation to cash equivalents.
I do not think it prudent to allocate a percentage of capital to cash. Better to determine a fixed amount you wish to maintain in cash. Then translate into a percent allocation for your overall target asset allocation.
The amount of assets you keep in cash depends on a few factors.
Needs and Opportunities Impact Cash Allocations
Cash for Planned Needs
Regardless of life cycle phase, allocate fixed amounts based on your needs and desires.
1. Determine what you want to maintain in emergency funds.
Funds that will cover 3-6 months fixed expenses.
If you have a solid asset base, then you probably own some lower volatility, higher liquidity, investments. Many people use these rather than pure cash for their emergency funds. Slightly more risk than cash, but also slightly higher returns.
2. Add in any money needed for planned short-term expenditures.
For Accumulators, this might be vehicles, wedding, children, debt repayment, etc. For Consolidators, a larger home, cabin at the lake, extra car, etc. For Spenders, vacations, known medical work, etc.
Cash for Unplanned Expenses
3. You might want to include a reserve for unplanned expenditures as well.
This may be especially prudent for Spenders. With no income other than savings and pensions, having cash available for unexpected costs (e.g., medical) may be wise.
But it may be a consideration for others as well. If personal circumstances dictate (e.g., health issues, young children, lack of medical or dental coverage at work, live in a location with violent weather, etc.) you may want to maintain a reserve for unplanned expenses.
Cash for Opportunities
4. Include a cash reserve for any investing opportunities that arise.
Always useful, but an area many people forget about.
It is nice to have free cash on hand should an interesting investment opportunity arise. Rather than not having the cash and missing out. Or having to sell another asset, incurring transaction costs and possible tax triggers, in order to invest in the new opportunity.
I suggest that this be an amount equal to what you may typically invest in any one asset. If you only invest $1000 at a time, that should be adequate. But if you normally invest in lumps of $20,000, your reserve will be higher.
Risk Tolerance and Personal Circumstances Affect Cash Allocations
How much you allocate to cash in each area will depend on your unique requirements.
If you work in a volatile industry with frequent layoffs, you may want to keep 6 months expenses in an emergency fund. If you work in a stable job, 3 months may suffice.
If you live in a hurricane belt, you might want to maintain some reserves for potential home damage and disruption of life.
How much you allocate will also be based on your personal risk tolerance.
The risk averse might want to save 6 months expenses regardless of how stable their employment is.
Aggressive individuals may want to keep little, if any, reserves for emergencies. Or the more aggressive may want to maintain their cash reserves in more risky cash assets such as foreign currency or short-term corporate paper.
The potential permutations are endless.
Once you total the above hard costs and factor in your risk tolerance, you will come up with the necessary cash component. Based on your total wealth, that will be the percentage that you need to allocate to cash equivalents.
As your circumstances change, while your needed hard costs may be the same, the percentage allocated to cash will shift.
Next, a look at fixed asset allocations.
